I've written in the past about using gift funds from a family member to aid in the purchase a home, including how to write a mortgage gift letter. But what if you're interested in using a no-interest loan from a family member, as opposed to a gift?

Well, assuming that you'll be using these funds in conjunction with a standard mortgage, it's always possible that you could ease the underwriting process by using a gift letter to satisfy the mortgage lender, even though the transaction is truly a loan (note that I'm not recommending this -- just saying that it's possible). While this might get around some difficulties with regard to underwriting, however, there are still some important IRS rules to deal with when it comes to making (or accepting) a loan of this sort...

In short, the IRS doesn't want people to use family loans as a tax dodge -- consider the case of a wealthy individual who provides their child (who resides in a lower tax bracket) with a no-interest (or even low interest) loan such that they can invest it and pay far less in taxes. While this was once possible, that loophole has now been closed. Indeed, the IRS now assumes that interest is being charged on the loan amount, and they further treat this uncollected interest as a gift. And if the amount of uncollected interest exceeds the Federal gift tax exclusion, the lender may be liable for gift taxes.

As is the case with nearly all IRS regulations, however, there are exceptions. First and foremost, if the amount of the loan is $10,000 or less, the IRS will simply ignore it. And for loans of up to $100,000 the IRS will not get involved as long as the borrower's investment earnings don't exceed $1,000 per year.

If your loan doesn't fall under one of these exemptions, then it's subject to the IRS's imputed-interest rules (this is sometimes also referred to as 'phantom' interest). What this means is that the IRS will do you the favor of calculating the interest dues based on IRS-set rates (the 'applicable federal rate' or AFR), and will then tax the lender for the foregone interest. Another wrinkle (and this one actually works in your favor) is that the taxable interest cannot exceed the borrower's investment earnings for the year. Note that, even if this is not an interest-free loan, the imputed-tax rules could kick in if the interest rate falls below the AFR -- in this case, the imputed interest would be proportional to the difference between the AFR and the actual rate being charged.

As a quick (and very simple) example, assume that Bob borrows from his parents an amount in excess of the $10,000 threshold under which the IRS will ignore the transaction. This is a no-interest loan that is intended to help Bob by a house but, as it turns out, Bob ends up earning $1,700 in interest and dividends from his investments. Now let's assume that the IRS does the imputed interest calculations and concludes that Bob should have paid $3,300 in interest. In this case, the loan interest is taxable (since Bob's investments earned more than $1,000), but the taxable amount (for the lender) is just $1,700 instead of $3,300 (i.e., it's capped at Bob's investment earnings).

Another thing to watch out for is that, if the loan is used to purchase an income-producing asset, the loan automatically falls under the imputed interest rules.

[Source: H&R Block]

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"Rules Regarding No-Interest Family Loans" was first published at fivecentnickel.commortgage calculator